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Thursday, June 30, 2016

Corporate Boards: Stop Expecting the Impossible?

Economists have been worried about what is often called the "separation of ownership and control" in large corporations since at least 1932, when Adolf A. Berle, Jr., and Gardiner C. Means wrote a book called The Modern Corporation and Private Property. The shareholders who legally own the company are technically represented by a board of directors, who then oversees the top executives who control the company on a daily basis. But when an Enron-style corporate scandal occurs, or when top executives receive very high levels of compensation, concerns arise that boards of directors have failed in their task of monitoring the firm.

But what if the entire vision of expecting corporate boards to monitor daily operations of large companies is simply implausible? Steven Bovie, Michael K. Bednar, Ruth V. Aguilera, and Joel L. Andrus argue that this is the case in "Are Boards Designed to Fail? The Implausibility of Effective Board Monitoring," which appears in a 2016 issue of the Academy of Management Annals (10:1, pp. 319-407). They offer an extensive review of the literature on how well corporate boards perform the function of monitoring companies, and conclude that such monitoring often doesn't work very well. They write:

"In fact, most academic research, popular press accounts, and even U.S. legislation all echo the sentiment and deeply held belief that boards should be able to actively monitor and control management. ... Our review focuses on literature that directly or indirectly explores one of the core assumptions of governance research-that a correctly designed and staffed board will be able to properly fulfill its primary function of effectively monitoring managerial action. The fundamental question that we hope to shed light on is the following: Is it reasonable to expect that boards can offer effective ongoing monitoring of firms, even if we assume that directors are sufficiently qualified and motivated? ... Specifically, we outline a number of barriers stemming from information-processing challenges that ultimately inhibit directors from pro­viding effective oversight on an ongoing basis. ... Our review and assessment of the literature suggests that effective, ongoing monitoring of managerial action is unlikely in most large corporations due in large part to these varied barriers."

What sort of barriers do they have in mind? For starters, effective board members should have what they call "board capital," meaning that they have personally invested the time and energy to have a fairly deep level of knowledge about the specific company, and also that board members should be compensated in a way that provides the right incentives to act in the interests of shareholders, not corporate insiders. The issues involved here are substantial! But drawing on their review of the literature on why board monitoring has often been ineffective, they argue that even when these conditions are reasonably well-met, directors typically face substantial problems in monitoring, which can stem from basic issues like firm size, firm complexity, outside job demands, complexity of those job demands, dissimilarity of those job demands, size of the board, frequency of board meetings, diversity of the board, norms of deference of the board, and power of the existing CEO.

Given the research reviewed in this article, we are pessimistic about the possibility of boards being able to effectively monitor managers on an ongoing basis in many circumstances. ... Given the size and complexity of many modem firms, we believe some firms may effectively be "too big to monitor", and that successful monitoring by boards may be highly unlikely in many large public firms. It might be time to concede that our conception of boards as all-encompassing monitors is doubtful ... After many of the corporate scandals over the past several years, the initial reaction has often seemed to be "where was the board?" Our review calls into question whether boards are really equipped to catch or stop misbehavior. Governance failures are likely to often be the result of the many barriers that we have outlined in this review, rather than directors who are shirking their duty as is often assumed.

What are some implications of this line of argument for corporate monitoring and the purposes of corporate boards of directors?

First, it's possible to improve the ability of boards to do monitoring on all of these dimensions, and such efforts can be worthwhile. Somewhat improved monitoring by corporate boards is likely better than no monitoring by boards.

Second, given that even improved board monitoring is likely to be highly imperfect, it's important to think about how to strengthen, emphasize, and rely on the other social mechanisms beyond corporate boards for monitoring the ongoing operations of firms. For example, there is analysis from investors and sources of finance like banks. There are reports of auditors, and government rules about how such audits should be done. There are articles in the financial press. Most industries have oversight in some dimensions (say, workplace safety, product safety, or environmental laws) by government regulators. There can be groups representing workers, including unions, and groups representing various community stakeholders.

Third, when evaluating whether a corporate board is performing well, it may be useful to knock expectations about the extent of monitoring down to more reasonable levels. Instead, in many cases the most important aspects of a corporate board may involve tasks like "providing resource," meaning as a source of expert advice and connections to corporate management, ans well as dealing with "punctuated events" like replacing the CEO or a big decision about a merger. Bovie, Bednar, Aguilera, and Andrus write: "Consequently, we believe that future research and theorizing needs to focus on boards as advice-giving bodies, or bodies that get involved in punctuated events, and look to other corporate governance mechanisms to secure monitoring."

For a quite different vision of overhauling corporate boards, a couple of years ago I discussed a proposal to "Outsource Corporate Boards?" (August 28, 2014).